Inside the numbers: Using gaps to interpret market direction

A gap happens when a financial instrument’s price makes a sharp move either to the upside or downside, skipping over certain prices in the process. Visually speaking, a gap creates a hole, or a void, on a price chart.

Gaps often are created during earnings announcements, surprise corporate news for a particular company, when analysts upgrade or downgrade a particular stock, when a company launches some new product or amid far-reaching economic or political events. Whatever the reason, the news typically breaks when the market is closed. The result is buying or selling pressure before and at the start of the next session’s trading that causes the instrument to open at a price outside the range of the previous day.

Gaps can occur in either direction:

Gap up: Occurs when the current day’s low is greater than the previous day’s high. On an interim basis, a provisional gap up forms when the current day opens above the previous day’s high.

Gap down: Occurs when the current day’s high is less than the previous day’s low. On an interim basis, a provisional gap down forms when the current day opens below the previous day’s low.

Consider the chart “Bite out of Apple” (below). On Nov. 16, 2012, Apple closed at $527.67 per share. On Nov. 19, it opened at $540.62. Because no shares changed hands between $527.67 and $540.62, a provisional gap of $12.95 per share formed. In this case, the provisional gap held, as the open also was near the low of the day. Similarly, on Dec. 3, Apple closed at $586.19, and on Dec. 4, it gapped down to $581.79. Again, the gap held, and the market traded lower, establishing a gap of $4.40 per share.